Operational Issues Associated with an IBS · OPERATIONAL ISSUES ASSOCIATED WITH AN IBS 35 n If nothing is done to make government policymakers more accountable for granting ‘‘too

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3Operational Issues Associatedwith an IBS

Laying out the general case for an IBS is one thing. Writing the specificsof such a standard is another. Much of the devil is in the details. In thischapter, I offer specific answers to the following key questions:

n Should the IBS be a unitary or two-level standard?

n What elements of banking and banking supervision should an IBSinclude?

n Who should set the standard?

n How should compliance with an IBS be monitored and encouraged?

Before addressing those specific operational issues, I will consider eightbroad points about what an IBS can achieve and how it ought to bedesigned.

Broad Features of an IBS

First, an IBS is not a panacea. It would be unrealistic to expect an IBS toeliminate banking crises in developing countries—particularly if thesecountries do not make significant progress in reducing macroeconomicinstability and the size and frequency of exchange rate misalignments.When the macroeconomy is in trouble and the real exchange rate isallowed to get way out of line, the banking system is sure to suffer.An IBS can improve mechanisms that cushion against macroeconomicvolatility—bank capital, provisioning for loan losses, etc.—and it canreduce the independent contribution of banking-system weakness to anunhealthy macroeconomic environment. But an IBS cannot be a substitute

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34 THE CASE FOR AN INTERNATIONAL BANKING STANDARD

for disciplined monetary, fiscal, and exchange rate policies, and it cannot engi-neer structural changes in the real economy (such as greater diversificationin a country’s export structure) to reduce volatility.1

Also, even in countries with the most developed systems of bankingsupervision, many future bank failures go undetected during bank exami-nations. For example, a recent Federal Deposit Insurance Corporation(FDIC) (1996) study found that of the US banks that failed from 1980 to1994, 36 percent of them had received the highest bank examinationratings (that is, CAMEL ratings of 1 and 2) two years prior to failure.2

An IBS should be seen as part of a comprehensive reform effort forbanking and banking supervision (that would also include increased train-ing for bank supervisors and improvements in the broader financial andlegal infrastructure). A realistic objective for an IBS is that it lead to alower frequency of serious banking crises in developing countries thanwould occur in its absence; given the costs of past banking crises indeveloping countries, this objective—if it can be achieved—would repre-sent an important accomplishment.

Second, if an IBS is going to make a real dent in the incidence ofserious banking crises in developing countries, it will need to encompassan interrelated set of banking system and supervisory reforms. Changing oneor two elements of the banking architecture is unlikely to make a largedifference. For example:

n If nothing is done to improve accounting and provisioning practices,neither statements of a bank’s financial condition nor measures of bankcapital will be accurate; as such, public disclosure will not fortify marketdiscipline, and prompt-corrective-action supervisory measures basedon capital-zone tripwires will be ineffective.

n If nothing is done about connected lending, increasing capital require-ments for banks will not alter the incentives for excessive risk takingby bank owners.

n If nothing is done to institute prompt corrective action by bank supervi-sors, there may be little consequence of bank capital—even correctlymeasured—dropping below the regulatory requirement.

1. As emphasized in chapter 2, a lack of diversification in the loan book of developing-country banks countributes to their vulnerability.

2. If one excludes types of bank failures that cannot be anticipated by safety and soundnessexaminations, as well as bank examinations that were more than one year old, the percentageof failed banks that had CAMEL ratings of 1 or 2 two years before failure drops to 16percent (FDIC 1996). CAMEL is an abbreviation for five components of bank soundness:capital, assets, management, earnings, and liquidity. In an earlier study of the same issue,Benston (1973) found that of US commercial banks that failed from 1959 to 1971, almost 60percent had been rated ‘‘no problem‘‘ on the last bank exam prior to collapse. Benston(1973) goes on to argue that the main reason examinations fail to predict bank failures is


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OPERATIONAL ISSUES ASSOCIATED WITH AN IBS 35

n If nothing is done to make government policymakers more accountablefor granting ‘‘too big to fail’’ assistance to severely undercapitalizedbanks, then private creditors will not heed any improved public infor-mation on banks.

n If nothing is done to reduce the proclivity of governments to use banksas their quasi-fiscal agents, efforts to improve the credit review processare apt to be frustrated.

n If nothing is done to buttress the legal authority of bank supervisors,then tougher prudential standards are not likely to be enforceable.

In other words, there is a critical mass of reforms in developing countriesthat, if not achieved, may result in little improvement in the bottom line.

One frequent criticism of such a comprehensive approach to bankingreform is that some of these elements would go beyond the traditionaljurisdiction of banking supervisors (e.g., the Basle Committee of BankSupervisors). For example, efforts to increase the transparency of govern-ment involvement in the banking system (by, for example, including suchquasi-fiscal operations in the government’s budgetary figures) are morethe responsibility of the IMF than of the Basle Committee. Similarly,international accounting standards fall in the sphere of the InternationalFederation of Accountant’s International Accounting Standards Commit-tee (IASC). Facilitating bank seizure of collateral on nonperforming loansinvolves changes in countries’ legal codes. And better preparation forfinancial liberalization will require, inter alia, more training of bank super-visors, which is part of ongoing activities of the World Bank and theregional development banks.

My rebuttal to the jurisdictional argument is that if serious bankingreform requires a coordinated effort among bank supervisors and otherinterested official parties, then a vigorous effort should be made to obtainsuch cross-agency cooperation. If that means one official institution cannotbe solely responsible for designing an IBS, so be it.3

Third, an IBS does not imply (full) international harmonization of bank-ing standards. So long as an IBS is designed as a minimum set of internationalbanking standards, it represents only a partial international harmonizationof standards, that is, it still leaves room—beyond the minimum—forindividual countries to maintain their national preferences toward risk,as well to maintain some of their institutional diversity.4 For example, ifArgentina wants its banks to disclose more information on their financial

that a leading cause of failure is fraud or misdealing, and bank examinations are not effectivein detecting these kinds of problems.

3. This issue will be taken up again later in this chapter.

4. For a discussion of different levels of harmonization of international regulatory standards,see Herring and Litan (1995). For an analysis of why it is not desirable to impose the same


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condition than stipulated in the IBS, it would be free to do so. Likewise,since an IBS would not step into the debate on the securities and insuranceactivities of banks, it would not stop France and Germany from maintain-ing their universal banking structures, while the United States and Japancould continue their de jure limitation on such activities by banks. AnIBS that stops well short of full harmonization of banking structures andsupervisory practices merits emphasis because, as illustrated in appendix C,tables C.1 and C.2, there remain significant differences on these matterseven among the G-10 and EU countries.

Fourth, an IBS would not necessarily decrease competition in the bank-ing industry. As highlighted by L. White (1996), in industries wherenational governments act to reduce competition, an international standardcan serve to reduce national protectionism. Two examples suffice to illustratethe point. If governments provide state-owned banks with cheap capitaland routinely bailout such institutions when they suffer large credit losses,an IBS that discourages these subsidies (or taxes) can increase globalcompetition in the banking industry. Likewise, if generous national safetynets induce banks to substitute official (implicit or explicit) safety-netguarantees for private capital, then an IBS that sets a minimum interna-tional capital standard can reduce these national subsidies toward banksand increase competition (L. White 1996).

Fifth, like other international regulatory initiatives, an IBS needs toconfront the test that there be market failures, externalities (spillovers), orpublic goods that extend beyond national borders, and that cannot be handledadequately by national regulation (Herring and Litan 1995; L. White 1996).As argued in chapter 2, I believe an IBS can pass that test: there arenontrivial cross-border spillover effects of developing-country bankingcrises; there are market failures associated with asymmetric information,with connected lending, and with heavy involvement of national govern-ments in the banking industry; and accurate and timely public informationon the financial condition of banks has attributes of a public good. Also,based on the history of the past 15 years, it is unlikely that competitionamong national banking regulators in developing countries will motivateserious banking reform.

Sixth, an IBS must consider the costs of regulation and the possibility thatflawed or outmoded regulations could make matters worse. That is, therecan be government failure as well as market failure. 5 It is partly for thisreason that an IBS ought to be voluntary. If countries view the costs ofparticipating in an IBS as higher than the benefits, they need not sign up.Similarly, if they decide that changes in the structure of the banking

organizational structure on financial markets in all countries, see Kaufman and Kroszner(1996).

5. See Merton (1995) for a discussion of the risks associated with implementing the wrongglobal regulatory standard.


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industry have made an IBS outmoded or counterproductive—and agree-ment can not be reached on a revision of the IBS—they can withdraw.In this sense, countries will vote with their feet as to whether the IBS isa club worth joining.

Seventh, an IBS should include both quantitative and qualitative elements.The prescription for some regulatory and supervisory problems (e.g.,minimum bank capital ratios, limits on connected lending) can and shouldbe delineated in quantitative terms, but many other problems (improvedpublic disclosure, prompt corrective action on the part of bank supervi-sors, stricter accounting and provisioning practices, etc.) are best handledprimarily in qualitative terms. Indeed, appendix B shows that many ofthe more useful international guidelines in the financial area have beenqualitative in nature. Whether quantitative or qualitative, IBS guidelinesneed to be specific enough to serve as benchmarks for performance evaluationby the monitoring agency (e.g., it will not be sufficient to call for appro-priate asset classification unless some indication is given about what‘‘appropriate’’ means).

Eighth, as with the IMF’s SDDS, countries (not individual banks) wouldsign on to an IBS. Once a country agreed to participate, it would alter itsnational banking laws (if necessary) to accommodate any features of theIBS not already included; at that point, a country’s banks would be cov-ered.6 But what about banks in a country that chose not to participate inthe IBS? In that case, individual banks wanting to distinguish themselvesfrom their less creditworthy competitors could indicate that they volunta-rily comply with all elements of an IBS under their control (much in thesame way that some derivative dealers advertise that they voluntarilyimplement the G-30 guidelines on risk management of derivatives).Admittedly, they could not claim that national supervisory practices weresubject to international monitoring, but they still might get some marketpremium by subscribing to a higher code of conduct.

A Unitary or Two-Level Standard?

An IBS could be a unitary standard applicable to all countries, or alterna-tively, a two-level standard where countries themselves would decide atwhich level to join. All previous international banking agreements have

6. Should all banks be covered or only internationally active banks? The Basle CapitalAdequacy Accord, for example, was directed only at the latter group. The rationale forcovering only internationally active banks is that these banks generate the largest interna-tional spillovers. The argument for wider coverage is that widespread failures at domesticbanks generate (smaller but still) nontrivial spillover effects; domestically oriented banksrepresent too large a share of vulnerability to ignore; and, as developing countries increasetheir financial links with the rest of the world, more of their banks will become internationallyactive. I would argue for the wider definition of participating banks.


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been unitary standards. It is argued that a unitary standard ensures allcountries receive uniform treatment; it is also easier to administer.

Despite these considerations, I vote for a two-level standard on threegrounds: differences in country circumstances, relevant transition periods,and lessons from standards in other areas. Moreover, potential difficultieswith a two-level mandatory standard are reduced when the IBS is volun-tary instead.

Some of the most widespread and severe banking problems are amongthe transition economies and developing countries of Africa and Asia.Yet financial and banking structures and the degree of market orientationin these countries are typically quite different from those in the moreadvanced emerging economies. What is of first priority and feasible inthe way of banking reform is therefore likely to be different in say, China,Russia, and India than in say, Hong Kong and Chile. For example, theshare of total banking assets owned by the state is almost 90 percent inIndia, whereas it is zero in both Hong Kong and Singapore. A two-levelstandard would better accommodate these differences.

A two-level standard would lead to a more desirable transition periodthan would a unitary one. Note that implementation of the Basle Accordon risk-weighted capital standards took four years for the G-10 countries;similarly, as noted earlier, implementation of the Minimum Standardsguidelines has been incomplete and uneven across countries four yearsafter its agreement. The IMF’s SDDS, applicable only to countries heavilyinvolved in international capital markets, will have a transition period oftwo and one-half years. If there is a unitary standard, then a choice mustbe made between setting it at a high level (i.e., ‘‘best practice’’ guidelines)or a low level (i.e., a minimum standard); the former could imply thatmany developing countries could not meet the standard for very consider-able periods of time (perhaps a decade or more), while the latter maynot yield much incentive for the emerging market economies to makeimportant further improvements in their regimes.

Looking beyond international banking agreements, two-level standardsare more common, especially when such agreements are meant to covera heterogeneous group of countries. The IMF’s Articles of Agreement,for example, specify that countries can adopt transitional arrangements(Article XIV status) before accepting the obligations of current-accountconvertibility (Article VIII status). At present, more than a third of theIMF’s member countries still avail themselves of such transitional arrange-ments. There is an even closer parallel with the IMF’s new data standards,which features a basic, transitional standard that all countries shouldsatisfy, and a stricter standard that would apply to countries that aremore heavily involved with international capital markets. Global andregional trade agreements, likewise, often specify longer transitional peri-ods for developing countries. For example, APEC’s recent ‘‘free trade’’


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commitment calls for industrial countries to meet the target by 2010, butgives developing countries until 2020.

A similar arrangement might work for an IBS: an upper level (stricter)standard that would probably attract banks and countries more heavilyinvolved with international capital markets and a basic (transitional) stan-dard that would apply to all participants. The main incentive to sign onto the higher standard would be the market premium attached to havingsatisfied more rigorous entry qualifications. But other incentives couldalso be contemplated. For example, in line with supervisory arrangementsin the United States, countries and banks meeting the higher standard(including higher capital requirements and stricter disclosure) could besubject to lighter supervisory oversight.

So long as subscription to an IBS is voluntary and qualification for bothlevels is based on objective criteria rather than merely an industrial-country/developing-country classification, administering a two-levelstandard might not be much harder than administering a unitary one.Also, claims of ‘‘unequal treatment’’ would carry less weight. If countriesrather than the monitoring agency choose the level they subscribe to, themonitoring agency need not decide when to ‘‘graduate’’ countries fromthe lower level to the upper one; instead, it would reject or accept acountry’s application based on objective criteria for a given level.

As regards equal treatment, there is a strong case against assigningindustrial countries ex ante to the upper level and developing countriesto the lower one—even though the primary focus of an IBS is on improvingbanking systems and banking supervision in developing countries andex post most industrial countries would probably be in the upper leveland most developing ones in the lower level (at least to start). Just becausethe incidence of serious banking crises in industrial countries has beenlower than in developing countries over the past 15 years does not meanthat banking systems/banking supervision in industrial countries are freefrom serious shortcomings. For example, ‘‘evergreening’’ of badloans (i.e., poor asset classification) and regulatory forbearance havebeen prominent features of the ongoing banking crisis in Japan. Heavyand misguided government involvement has been evident in the sizablepublic bailout of Credit Lyonnais in France. Poor preparation for financialliberalization was instrumental in the late 1980s/early 1990s bankingcrises in Finland, Norway, and Sweden. Poor internal controls were a keyfactor in the recent troubles at Daiwa and Barings. And the bitter fruitsof an incentive-incompatible official safety net were dramatically illus-trated in the US saving and loan crisis.7 In short, industrial countries

7. See Goldstein et al. (1993) for a discussion of these industrial-country banking problems.Calomiris and White (1994) have calculated that the deposit insurance cost to taxpayers ofthe US saving and loan debacle exceeded in real magnitude the losses of all failed banksduring the Great Depression.


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should not get a free ride; they need to satisfy the same objective entrycriteria as developing countries do. An IBS can therefore be a vehicle formotivating further improvements in industrial-country banking systems.

Any IBS that discriminated against developing countries would notprovide those countries with the proper incentives for reform. For exam-ple, if one could make the case on objective grounds that say, Hong Kongand Chile were better placed to qualify for an upper-level IBS than a fewindustrial countries, that differentiation should not be thwarted by somecountry-group classification. Following the same line of argument, itwould be totally inappropriate to design an IBS only for developingcountries. There can be different levels of certification, but qualificationfor those levels must be nondiscriminatory.

While I believe that a two-level IBS would be superior to a unitarystandard, the latter would be much better than having no IBS at all.

What Should an IBS Include?

To be truly comprehensive, an IBS would need to specify guidelines forall the important aspects of banking supervision, including, inter alia:deposit insurance; lender-of-last resort operations; bank licensing andpermissible banking activities; external audits; internal controls and inter-nal audits; information requirements of bank supervisors; public disclo-sure; limits on large exposures and connected lending; capital adequacy;asset valuation and provisioning; foreign-exchange exposures; on-sitebanking inspections; legal powers and political independence of banksupervisors; the mix between rules and discretion in the implementationof corrective actions; globally consolidated supervision; cooperation(including exchange of information) between home- and host-countrysupervisors; and measures to combat money laundering.8 In addition, onewould want to offer some guidance on the relevant infrastructure forgood banking, including: interbank and government securities markets;payments, delivery, and settlement systems; and the legal and judicialframework.

Clearly, analysis of each of these elements would go beyond the scopeof this study. I will therefore concentrate on eight priority elements of anIBS, selected primarily for their past and potential contribution to banking crisesin developing countries. For each element, I attempt to convey the flavor ofwhat should be required, along with some indication of which provisionsmight be reserved for the stricter (upper-level) standard (if an IBS weredesigned as a two-level standard rather than a unitary one).

8. For an excellent analysis of ‘‘best practice’’ in each of these supervisory dimensions, seeIMF (1997a).


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Public Disclosure

IBS participants should be required to publish timely and accurate infor-mation on the financial condition of banks so that both sophisticatedprofessional investors and less sophisticated retail depositors can makean informed assessment of bank performance and profitability. At a mini-mum, such information should include a balance sheet, income statement,large off-balance-sheet exposures, and summary of major concentrationsof credit and market risk.9

This material should be prepared on a globally consolidated basis, inaccordance with international accounting standards, and should beaudited by a reliable independent external auditor.10 There should beenough detail so that readers can gauge the breakdown between interestand noninterest income and expenses, the relationship between nonper-forming loans and loan-loss provisions, how well or poorly the bank iscapitalized, and how profitable the bank is relative to its competitors (asrevealed by traditional indicators, such as the return on equity, the returnon assets, etc.). If a common format for such public disclosure of bankscould be agreed, this, like a common international accounting standard,would be most welcome (since it would both reduce transaction costsand facilitate comparisons among banks within and across countries). IBSparticipants would agree to review their legal codes to ensure that banksare liable for serious penalties if they are found to have been issuing falseor misleading information to the public.

For upper-level status, banks could also be required to display promi-nently their most recent ratings from internationally recognized credit-rating agencies (including any downgradings). If they have not beenrated, banks should disclose that fact. Upper-level participants would alsocommit to adopting public disclosure recommendations (jointly agreed bythe Basle Committee, IOSCO, and the Eurocurrency Standing Committee)on the trading and derivative activities of banks and securities firms.11

Appendix D provides two examples of good public disclosure—onefor the banking system as a whole and one for individual banks. The first

9. Later in this chapter, I introduce two additional disclosure requirements for IBS participa-tion, specifically related to the problems of government involvement in the banking systemand connected lending.

10. One problem here is that there are presently two competing international accountingstandards: International Accounting Standards as drawn up by the International AccountingStandards Committee and Generally Accepted Accounting Principles (GAAP) used in theUnited States. See W. White (1996) for a discussion of their relative advantages and disadvan-tages. Discussions are ongoing among accounting bodies in the major industrial countriesto see if agreement can be reached on a single international accounting standard. In theinterim, use of either GAAP or international accounting standards might be acceptable foran IBS.

11. See Basle Committee on Banking Supervision (1996) for an explanation of this disclo-sure agreement.


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shows the aggregate data published quarterly for 3,000 national banks inthe United States, while the second gives the disclosure requirements forindividual banks under New Zealand’s new supervisory regime.12

Accounting and Legal Framework

The aim here should be to move closer to internationally recognized loanclassification and provisioning practices and remove undesirable legalimpediments to the pledging, transfer, and seizure of loan collateral andto the statutory authority of supervisors to carry out their mandate.

IBS participants would agree to set out clearly the criteria and rules/practices they employ to classify loans, provision for loan losses, andsuspend accrual for overdue interest. In classifying loans, participantswould agree to give appropriate weight to an assessment of the borrower’scurrent repayment capacity, to the market value of collateral, and to theborrower’s past record, and they would not rely exclusively on the loan’spayment status.13 Participants would also pledge to discourage and moni-tor accounting devices that facilitate the ‘‘evergreening’’ of bad loans.14

The time a loan could be in arrears before it was classified as nonper-forming would be no longer than 150 days. For upper-level status, thattime period could be 90 days. Each participant should have mandatoryprovisioning rules against bad loans. For upper-level status, participantswould agree to meet an international provisioning standard (if one canbe agreed); pending such an agreement, upper-level participants wouldmaintain a provisioning coverage ratio (of loan-loss reserves to nonper-forming loans) not more than 10 percent below the Organization forEconomic Cooperation and Development (OECD) average for the previ-ous five-year period.

On the legal side, IBS participants would review their legal and commer-cial codes to certify that laws governing bankruptcy and recovery andpledging of collateral (for bank loans) do not impose undue costs on

12. Note that disclosure requirements for banks in New Zealand are more demanding thanthose in most other industrial countries, and that New Zealand’s new supervisory regimeplaces greater reliance on public disclosure (relative to prudential requirements) to disciplinebanks than do regimes in other industrial countries. It is sometimes argued that New Zealandcan afford to rely so much on disclosure because large banks in New Zealand are foreignowned and thus subject to supervision in their home country.

13. See Meltzer (1995) for a description and analysis of how Chile strengthened its assetclassification and provisioning regime.

14. De Juan (1996, 101) highlights three signs of ‘‘evergreening’’ and weak repaymentcapacity: ‘‘. . . (i) the financial statements of the borrower show negative net worth and/ornegative cash flow; (ii) the loan has a history of consecutive rollovers, and the volume ofeach new loan is equal to or above the principal plus interest of the previous loan; and (iii)the principal or interest of previous loans is not paid in cash, but through refinancingfacilities extended by the same creditor bank.’’


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banks. In addition, participants would confirm the legal authority ofbank supervisors to carry out their responsibilities (e.g., issuance andrevocation of banking licenses, requests for information, setting of pruden-tial guidelines/regulations, conducting on-site inspections, closure ofinsolvent banks, etc.).15

Internal Controls

Because of increased bank involvement in trading activities and the tre-mendous growth of complex financial instruments over the past decade,it is more difficult for bank supervisors and creditors to monitor accuratelythe risk profile of banks.16 During the same period, there have been severalnotable failures at financial firms (e.g., Barings, Daiwa, Sumitomo) wheretime-honored principles of prudent risk management (e.g., separation ofauthority as between front- and back-office operations and awareness bysenior management of the size of exposures) were violated (IMF 1996a).These developments underscore the importance of good internal controlsat banks as the first line of defense against excessive risk taking—be itmarket risk, credit risk, legal risk, or operational risk.

Participating banks would agree to have available for inspection a clearwritten account of what procedures and safeguards are in place as partof their internal risk management. It should address how risks are mea-sured and tracked in real time, which members of senior managementand the board are responsible for oversight and for ‘‘pulling the plug’’ ifactual exposures exceed prespecified limits, how exposure limits in theloan book and trading book are set, how different functional risks withinthe firm are segregated, how the consistency and accuracy of internalrecord keeping is cross-checked, the amount of capital that is availableto cover losses in various risk categories, what backup there is in case ofcomputer breakdowns or other information technology problems, andwhat safeguards have been introduced to discourage and detect fraudand money laundering. In addition, IBS participants should certify thata reliable, independent internal audit function is in operation. For upper-level status, participants would certify that banks with significant involve-ment in derivative markets are implementing the G-30 (1993) guidelineson risk management of derivatives, as well as the recommendations for

15. A particularly important area here is the ability of supervisors to get the data they needto evaluate a bank, including data on off-balance-sheet and off-shore activities; see IMF (1997a).

16. See BIS (1996) and IMF (1996a) for figures on the growth of the over-the-counter andexchange-traded derivative markets during the 1990s. Goldstein (1995b) and Hoenig (1996)discuss the difficulties that financial regulators face in trying not to ‘‘fall behind the curve’’in an innovative global capital market. Garber (1996) provides an account of how Mexicanbanks in 1994 used off-shore structured notes to evade national prudential regulations onnet open currency positions.


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combating money laundering promulgated by the Financial Action TaskForce on Money Laundering (1990).

Government Involvement

As highlighted in chapter 2, state-owned banks and burdensome develop-ing-country government involvement in privately owned banks havedrained public finances and generated inefficient resource allocation inbanking services. Despite this dismal track record, it is neither realisticnor desirable that an IBS call for immediate privatization of all state-ownedbanks or mandate an end to all policy-directed lending in developingcountries. After all, almost all countries have at some time intervened toinfluence the allocation of bank credit for what they deemed sociallydesirable purposes. Also, there may well be situations in developingcountries where some government involvement can be legitimatelydefended.

But what an IBS can do is bring greater transparency and accountabilityto government ownership and involvement in the banking system. Thisshould subject such operations to greater public scrutiny and make it moredifficult to use the banking system as a quasi-fiscal device to circumventlegislative and political constraints on the budget. Moreover, an IBS canencourage financial institutions that operate with policy-based lendingconstraints to give greater weight to commercial considerations in theircredit decisions, to avoid costly future bailouts. And an IBS can even askgovernments to consider more carefully whether privatization of some ormost of their state-owned banks would not be in their long-term interest.

Toward this end, IBS participants would agree to

n include in the government budget all government costs and quasi-fiscaloperations that involve the banking system (as recently recommendedby the IMF [1996b]);17

n annually publish data on nonperforming loans in state-owned banks(on a basis that permits comparison with privately owned banks);

n disclose the nature and extent of government instructions to banks onthe allocation of credit (be it in state-owned or privately owned banks);

n subject state-owned banks to an external audit by a private independentexternal auditor and publish the results of that audit; and

n direct state-owned banks to give due attention to creditworthiness intheir lending decisions.18

17. Mackenzie and Stella (1996) explain how one might define and measure quasi-fiscaloperations of public financial institutions.

18. Kaufman (1996a) urges developing countries where state-owned banks account for animportant share of total bank assets to recapitalize all banks so that they are market-value


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For upper-level status, countries where state-owned banks account for asignificant share of total banking assets would agree to review the costsand benefits of their state-owned banks, with an eye toward assessingthe scope for privatization of such institutions.

Connected Lending

IBS participants would establish an exposure limit on lending to connectedparties, endorse the principle that lending to connected parties should beon terms that are no more favorable than those extended to nonrelatedborrowers of a similar risk class, outlaw practices that make it difficultor impossible for supervisors to verify the accuracy of reported connected-lending exposure (e.g., use of fictitious names, dummy corporations, etc.),and publicly disclose the share of loans going to connected parties andthe identity of large shareholders and their affiliations.19 For upper-levelstatus, participants would establish below-maximum-limit thresholdreporting limits (to bank supervisors) on connected lending (to give super-visors advance warning of rapidly rising exposure to connected lending).

Bank Capital

Signatories to an IBS would adopt the existing 8 percent risk-weightedcapital standard for credit risk, along with the recent amendment formarket risk. To reflect the need for higher capital when the operatingenvironment is relatively volatile, countries seeking upper-level statuswould apply a ‘‘safety factor’’ if their recent history of loan defaults,restructured loans, and/or government assistance to troubled banks wassignificantly higher than the OECD average over say, the past five years.This safety factor could possibly involve multiplying the level I capitalrequirement by 1.5, so that ‘‘volatile’’ countries would apply a minimumrisk-weighted capital standard for credit risk of 12 percent. This approachwould respect the principle of equal treatment. Any country—industrialor developing—that had a relatively volatile operating environment forits banks would apply the higher requirement if it wanted to meet theupper-level standard. Also, a country’s actions to reduce that volatility

solvent, privatize to improve the incentives for banks and to reduce political pressures, putin place an incentive-compatible safety net, and resist or minimize nonprudential regulationsthat focus on political, social, or other objectives.

19. Exposure limits on connected lending should be additional to those on maximum expo-sure to a single borrower. According to a recent survey of the Basle Committee (Padoa-Schioppa 1996), 90 percent of countries do not allow lending to a single customer to exceed60 percent of the bank’s capital, and roughly two-thirds of countries maintain the stricterexposure limit of 25 percent of capital. See Goldstein and Turner (1996) for the exposurelimits on single borrowers in a group of emerging economies.


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(e.g., more stable macroeconomic policies) would, if sustained, eventuallybe reflected by a lower capital requirement. Much of this parallels theBasle Committee’s approach to determination of regulatory capital formarket risk (Basle Committee on Banking Supervision 1996; Padoa-Schi-oppa 1996).

An Incentive Compatible Safety Net and Resisting Pressuresfor Regulatory Forbearance

The aim here should be to retain the positive features of an official safetynet for banks (i.e., discouragement of bank runs and limitation of systemicrisk) while reducing its negative (moral hazard) effects (i.e., less marketdiscipline from bank creditors, excessive risk taking by banks, increasedcosts for taxpayers, and delay in enforcing corrective actions on undercapi-talized banks by financial regulators). To do that, the safety net mustincorporate incentives that tilt the behavior of the main players in theright direction.

The most promising approach to date for designing an incentive-com-patible official safety net is the system of structured early interventionand resolution (SEIR), put forward by Benston and Kaufman (1988) inthe late 1980s and incorporated with some modifications in US bankinglegislation in the early 1990s.20 The losses (at least $150 billion) incurredin the saving and loan debacle and the prospect of similar difficulties forUS commercial banks supplied the political motivation for reform. Thekey legislative vehicle was the Federal Deposit Insurance CorporationImprovement Act (FDICIA) of 1991. The underlying strategy has twopillars: first, to maintain deposit insurance for banks but to use regulatorysanctions to mimic the penalties that the private market would imposeon banks (as their financial condition deteriorated) if they were notinsured, and second, to reduce greatly the discretion that regulators havein imposing both corrective actions and closure of a bank.

The safety-net reforms embodied in FDICIA legislation can be summa-rized as follows: (1) government deposit insurance is retained for smalldepositors;21 (2) deposit insurance premiums paid by banks are risk weight-

20. Benston and Kaufman (1996) argue that while FDICIA was a big step forward in deposit-insurance reform, it should have set the capital-zone thresholds higher, used a simpleleverage ratio to measure capital (rather than using both this ratio and the Basle risk-weighted one), embraced market-value accounting, established stiffer penalties for FederalReserve lending through the discount window to banks that subsequently failed, madewider spreads between the deposit insurance premiums paid by the safest and riskiestbanks, and given even less scope for discretion in applying prompt corrective action andleast cost resolution.

21. The rationale for covering small depositors is that they might otherwise run into currencywhen banks get into trouble, they are generally less adept than large bank creditors inevaluating the true financial condition of banks, and they have enough political muscle


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ed (depending on their capital and bank examination rating); (3) banksbecome subject to progressively harsher regulatory sanctions (e.g., elimi-nating dividends, restricting asset growth, and changing management)as their capital falls below multiple capital-zone tripwires; (4) by the sametoken, well capitalized banks receive ‘‘carrots’’ in the form of wider bankpowers and lighter regulatory oversight; (5) regulators’ discretion issharply curtailed (with respect to initiating ‘‘prompt corrective actions’’and resolving a critically undercapitalized bank at least cost to the insur-ance fund (least cost resolution); (6) effective 1 January 1995 the insurancefund is generally prohibited from protecting uninsured depositors orcreditors at a failed bank if this would increase the loss to the depositinsurance fund; and (7) provision is made for a discretionary, systemic-risk override to protect all depositors in exceptional circumstances (whennot doing so ‘‘would have serious adverse effects on economic conditionsor financial stability’’)—but activation of this override requires explicit,unanimous approval by the most senior economic officials and subjectsany bailout to increased accountability (Benston and Kaufman 1988, 1996;Kaufman 1996a, 1996b). Table 3.1 summarizes the prompt-corrective-action features of FDICIA.

Proponents of SEIR argue that it improves incentives on at least fivecounts (Benston and Kaufman 1996; Kaufman 1996b). Because uninsuredcreditors of banks realize they will be at the end of the queue if a bankgets into trouble, they will monitor banks more assiduously, therebyenhancing market discipline. Because bank owners and managers knowthe penalties in advance if losses are sustained and banks become under-capitalized, they will be less inclined to engage in excessive risk takingand will not allow bank capital to fall too low. Because bank supervisorsare largely obliged to prompt corrective action and least cost resolution,they will be less susceptible to pressures for regulatory forbearance.Because the most senior economic officials know that granting ‘‘too largeto fail’’ assistance requires unanimous approval and involves increasedpublic scrutiny, they will be dissuaded from doing so unless there is aclear systemic threat at hand. And because the explicit closure rule callsfor resolving a failed bank while it still has positive net worth, losses tothe deposit insurance fund should be small (thereby making it less costlyto keep the fund fully funded).22 In contrast, safety-net regimes that donot incorporate SEIR often leave a key question unanswered: What hap-pens when bank capital drops below the regulatory standard?

anyway to force the government to bailout their losses if they were not covered by insurance(Kaufman 1996a).

22. If the deposit insurance scheme lacks sufficient financial resources, even insured deposi-tors may be tempted to run during periods of bank weakness; moreover, regulators willbe more inclined to grant regulatory forbearance because there are insufficient resourcesto liquidate the bank.


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Table 3.1 Summary of prompt-corrective-action provisions of the federal Deposit Insurance CorporationImprovement Act of 1991

Risk- Risk-based based Leverage

Zone Mandatory provisions Discretionary provisions total tier 1 tier 1

1. Well capitalized .10 .6 .5

2. Adequately capitalized 1. No brokered deposits, except with .8 .4 .4FDIC approval

3. Undercapitalized 1. Suspend dividends and 1. Order recapitalization ,8 ,4 ,4management fees 2. Restrict interaffiliate

2. Require capital restoration plan transactions3. Restrict asset growth 3. Restrict deposit interest rates4. Approval required for acquisitions, 4. Restrict certain other activities

branching, and new activities 5. Any other action that would5. No brokered deposits better carry out prompt

corrective action

4. Significantly undercapitalized 1. Same as for zone 3 1. Any zone 3 discretionary ,6 ,3 ,32. Order recapitalizationa actions3. Restrict interaffiliate transactionsa 2. Conservatorship or receivership4. Restrict deposit interest ratesa if it fails to submit or implement5. Pay of officers restricted a plan or recapitalize pursuant

to order3. Any other zone 5 provision,

if such action is necessary tocarry out prompt correctiveaction

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5. Critically undercapitalized 1. Same as for zone 4 ,22. Receiver/conservator within 90 daysa

3. Receiver if still in zone 5 four quartersafter becoming criticallyundercapitalized

4. Suspend payments on subordinateddebta

5. Restrict certain other activities

a. Not required if primary supervisor determines action would not serve purpose of prompt corrective action, or if certain other conditions are met.

Source: Board of Governors of the Federal Reserve.


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As acknowledged by Benston and Kaufman (1996), FDICIA has beenin operation for only five years, the US economy has not undergone amajor cyclical downturn during that period, and no US money-center bankhas become critically undercapitalized during this period. In addition,broader economic factors have no doubt contributed to the recovery ofthe US banks and S&Ls. It is, therefore, too early to come to a definitiveverdict on the effectiveness of FDICIA. Nevertheless, the preliminarysigns are encouraging. Not only are bank failures and bank problemsdown and bank capital and profitability up, but as shown in table 3.2, amuch higher share of uninsured depositors has gone unprotected sinceFDICIA came on stream. This is a strong signal that market discipline isbeginning to bite.

Some exporting of FDICIA is already going on. In drawing lessonsfrom its recent/ongoing banking difficulties, Japan plans to establish aprompt-corrective-action system in April 1998, and the banking laws ofsome developing countries (e.g., Chile) contain significant precommit-ment features. With no superior alternatives out there for reforming offi-cial safety nets, FDICIA-like features (to combat moral hazard and regula-tory forbearance) ought also be included in an IBS. For example, IBSparticipants could agree to make some corrective actions mandatory ifbank capital dropped below the regulatory minimum, ensure there is awell defined closure rule/procedure for banks, make it publicly knownthat uninsured creditors (including sellers of interbank funds) standbehind insured depositors and the deposit insurance fund in being pro-tected from bank losses, and require that granting of ‘‘too large to fail’’emergency financial assistance to banks be publicly approved by boththe governor of the central bank and the minister of finance.

Consolidated Supervision and Cooperation AmongHost- and Home-Country Supervisors

The Basle Committee on Banking Supervision has been on target in insist-ing that (1) all international banks be supervised on a globally consolidatedbasis by a capable home-country supervisor; (2) home-country supervisorsbe able to gather information from their cross-border banking establish-ments; (3) before a cross-border banking establishment is created, it receiveprior consent from both the host- and home-country authorities; and (4)host countries have recourse to certain defensive actions (e.g., prohibitthe establishment of banking offices) if they determine that conditions(1)-(3) are not being satisfied (Basle Committee on Banking Supervision1996). Participants in an IBS should therefore agree to implement the 1992Basle Minimum Standards.

Could an IBS be Agreed on?

So much for the makeup of an IBS. But wouldn’t an IBS represent suchan ambitious extension of existing international banking agreements as


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Table 3.2 FDIC banks’ resolutions, 1986–95 (by protection of loss of uninsured depositors)

Number of banks Total assets (billions of dollars)

Year Total Protected Not protected Percentage not protected Total Protected Not protected Percentage not protected

1986 145 102 40 28 7.6 6.3 1.3 171987 203 152 51 25 9.2 6.7 2.5 271988 221 185 36 16 52.6 51.3 1.3 31989 207 176 31 15 29.4 27.2 2.2 81990 169 149 20 12 15.8 13.3 2.5 161991 127 106 21 17 62.5 60.9 1.6 31992 122 56 66 54 45.5 25.0 20.5 451993 41 6 35 85 3.5 0.2 3.3 941994 13 5 8 62 1.4 0.6 0.8 571995 6 0 6 100 0.8 0.0 0.8 100

Source: Benston and Kaufman (1996).


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to preclude agreement? After all, several of these items were no doubtraised in the Basle Committee in previous years without garnering therequisite support. If agreement could not be reached among the G-10countries, wouldn’t it be unrealistic to expect agreement on a wider listof banking reforms among a broader group of countries?

I find this criticism unpersuasive. Prior to the Mexican economic crisisof late 1994 to 1995, few would have anticipated reaching agreement onan international standard for publication of economic and financial data(the IMF’s SDDS), or on doubling the IMF’s line of credit from the GeneralAgreement to Borrow and its extension to 14 new member countries, oron establishing a concerted official position on the rescheduling of sover-eign bank debt (the so-called ‘‘orderly workout’’ issue). Yet, barely twoyears after the onset of the Mexican crisis, the international communityhas reached agreement on all three (Goldstein 1996b).

In analyzing past international agreements in the area of financial stabil-ity, Kapstein (1992) identifies three underlying factors: a shared recogni-tion of a common problem, some agreement on how the financial systemshould function and how problems might best be addressed, and thecontinuing exercise of state power to make it happen. It is only withinthe last year or two, with the publication of several comprehensive studies,that the scope and severity of banking problems in developing countrieshas come to be more widely appreciated, particularly by observers in theG-10 countries (Lindgren, Garcia, and Saal 1996; Caprio and Klingebiel1996a, 1996b; Honohan 1996). And, it is only recently that research hasproduced a reasonable consensus on the factors behind these bankingcrises and the policy changes that would help to alleviate the problem(Caprio and Klingebiel 1996a, 1996b; Goldstein 1996a; Goldstein andTurner 1996; Kane 1995; Kaufman 1996a; Meltzer 1995; Rojas-Suarez andWeisbrod 1995, 1996a, 1996b, 1996c, 1996d). As regards leadership fromthe official sector, it was only at the Lyon Summit in June 1996 that G-7heads of state (G-7 1996, 3) put the ‘‘. . . adoption of strong prudentialstandards in emerging economies’’ on their crisis prevention agenda, andit has been primarily during the past six months that senior internationalpolicymakers have begun to stress the need for a coordinated internationalapproach to banking problems in developing countries (G-7 1996; Camd-essus 1996; Summers 1996; Pou 1996). In short, each of Kapstein’s (1992)criteria for agreement are considerably closer to being satisfied now thanthey were even three years ago. What could be agreed then is not necessar-ily what can be agreed now.

Who Should Set the IBS?

Since more robust banking systems and more effective banking supervi-sion would be in their common interest, an IBS ought to be sponsored


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jointly by the international financial institutions (the IMF, World Bank,and BIS), the Basle Committee on Banking Supervision, regulatory andsupervisory authorities from the developing world, and representativesof the banking industry. But who should set the specific guidelines foran IBS?

The main expertise needed to draft an IBS is banking supervision. Thissuggests that the Basle Committee on Banking Supervision should playa key role in the exercise, that is, they should draft the key provisions of theIBS that relate specifically to banking supervision. The Basle Committee’sleadership would give the IBS a brand name and provide a sense ofcontinuity with earlier international banking agreements.

But the Basle Committee should not be the only group working on anIBS, for at least four reasons.

First, as outlined above, a good IBS would be somewhat broader indesign (e.g., international accounting standards, greater transparency forgovernment involvement in the banking system, etc.) than the confinesof traditional banking supervision; as such, other groups that have moredirect responsibility for these adjacent issues (e.g., the IASC or IMF)should be involved and their contributions folded into the final product.Such interagency collaboration would be even more essential if the ulti-mate aim were not merely to produce an IBS but rather to a produce aminimum international standard for, say, banking and securities activities;in that case, the guidelines of securities regulators (i.e., IOSCO) shouldbe folded into the IBS into the broader standard. In either case, someinternational umbrella group at a higher level than the Basle Committee(e.g., the Interim Committee of the IMF or a working group of ministers offinance and central bank governors from larger industrial and developingcountries) would need to coordinate the assembly of the final product.

Second, and pointing in the same direction, because an IBS introducessome issues not raised by earlier international banking agreements (e.g.,international monitoring of national supervisory regimes), enlarges theintersection between the microeconomic and macroeconomic aspects offinancial regulation, and would require large changes in banking practicesin some countries, the Basle Committee’s collaboration with other inter-ested parties should be more extensive and intensive than normal. Forexample, if the international financial agencies (the IMF, World Bank,and regional development banks) were assigned the tasks of advisingcountries on how to alter their banking and supervisory arrangementsto conform to an IBS, of monitoring participating countries’ compliancewith the standard (as discussed later in this chapter), and of intensifyingtheir normal financial surveillance and financial-sector restructuringwork, then their views ought to be sought as to whether any guidelinesdrawn up by the Basle Committee are sufficiently specific and comprehen-sive. Their views would be particularly valuable on whether any consen-


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sus on an IBS reached in the Basle Committee had ducked some of thetough issues (e.g., whether countries with volatile operating environmentsshould have higher regulatory capital requirements, whether an IBSincludes incentives that will reduce over time government involvement inthe banking system, etc.) that are apt to be crucial in reducing the vulnerabil-ity of developing-country banking systems. Given BIS’s considerable exper-tise in the intersection of the micro and macroeconomic elements of financialregulation, it should likewise be accorded an important role in reviewingany draft IBS guidelines produced by the Basle Committee.

Third, the banking industry needs to be given ample opportunity torecord its views on what elements should and should not be included inan IBS; after all, it is the banking industry that would need to absorb anycosts associated with meeting the requirements of an IBS. The influenceof their input should not be minimized. For example, the decision by theBasle Committee to permit banks to employ their own internal risk-management models to help calculate regulatory capital requirements formarket risk occurred only after banks in several larger industrial countriesexpressed their dissatisfaction with the earlier proposal to base thesecapital requirements on a preset formula.23

Fourth, the group that sets the IBS should have strong representationfrom developing countries. Since developing-country banking systemsand banking supervision are the primary focus of the IBS exercise, thedrafting group needs to have firsthand experience with developing-coun-try banking supervision issues. Without that experience, the IBS guidelinesare not likely to be as well suited to the practical banking problems facedby developing countries as they could be with strong representation fromthese countries. Without adequate support from the developing countries,an IBS is unlikely to get off the ground. Some groups in developingcountries are likely to resist the banking reforms necessary to qualify forIBS admission; some may even argue that an IBS is a scheme by industrialcountries and their banks to reduce the competitiveness of developing-country banks by imposing onerous prudential standards—standards thatmany industrial countries will already have met or exceeded. Spokesper-sons for banking reform in developing countries will be better able toovercome opposition and convince their publics and their banking indus-tries that such (voluntary) reforms are in the best interest of their countryif they can legitimately say that they were full participants in drafting anIBS. Although the Basle Committee presently includes only bank supervi-sors from G-10 countries, there is no reason why the working group thatdrafts the IBS should not include significant representation from developingcountries. Developing-country representatives should also serve on anyother working groups that are contributing to an IBS.

23. See IMF (1995) for a discussion of this background to the recent amendment of theBasle Capital Adequacy Accord to cover market risk.


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In the end, after the interagency collaboration is complete, there mustbe full agreement on the guidelines in an IBS. If, for example, the IMFand World Bank had a different view on minimum standards for account-ing and provisioning than did the Basle Committee, countries participat-ing in an IBS would not understand their obligations and the monitoringprocess would be unnecessarily complicated. When the smoke clears,there can be only one IBS.24

How Should Compliance with an IBSBe Monitored and Encouraged?

This is probably the single toughest operational issue facing an IBS. Thereare basically two approaches.

The traditional one, at least in the field of international banking agree-ments, is to have international recommendations ratified by ministersand governors, incorporated into national law or regulation, and thenmonitored/enforced by the national banking supervisor (W. White 1996).This approach has its advantages. By maintaining home-country control,the chances that reforms are ‘‘owned’’ by the home country are maxi-mized, and the criticism that conditions are being imposed by an interna-tional agency are avoided. Also, national supervisors are apt to be moreknowledgeable about local banking conditions than an outside groupwould be.

The rub is that exclusive home-country control will weaken the imple-mentation/credibility of an IBS in those countries where weak bankingsupervision is part of the problem. In those cases, an independent outsidemonitor should render an objective evaluation of whether an IBS is beingimplemented as agreed. A hint of the complacency that might be associ-ated with home-country monitoring is offered by a recent Basle Committeesurvey (Padoa-Schioppa 1996), which covered 129 countries: two-thirdsof the countries reported that the supervisory agency is independent fromthe government; only 13 countries acknowledged that their banks grantloans in compliance with governmental directives; 72 percent of nonindus-trial countries responded that they do not allow lending to a single cus-tomer to exceed 25 percent of the bank’s capital; and over 90 percent ofall countries reported that supervisors verify the adequacy of bank’saccounting systems. It makes you wonder. Either all those studies showingpolitical pressures on supervisors, government-directed lending, con-nected lending, and weak accounting systems to be major factors in bank-ing crises were wrong (BIS 1996; Caprio and Klingebiel 1996a, 1996b;

24. This is not to say that in their financial surveillance and financial restructuring work,the IMF and the World Bank should not address areas that are not covered in an IBS. Butfor the areas that are covered, everyone has to be singing from the same hymn book.


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Folkerts-Landau et al. 1995; Goldstein and Turner 1996; Honohan 1996;Lindgren, Garcia, and Saal 1996; Meltzer 1995; Rojas-Suarez and Weisbrod1996a, 1996b, 1996c, 1996d; Sheng 1996), or there has recently been atremendous improvement in supervision.

The second approach is to entrust at least part of the monitoring to aninternational agency. This has been a long-standing practice in the areasof trade policy, macroeconomic stabilization, and sectoral reform (includ-ing the financial sector); note the roles of the General Agreement on Tariffsand Trade (GATT)-World Trade Organization (WTO), IMF, World Bank,and regional development banks (e.g., European Bank for Reconstructionand Development, Inter-American Development Bank, Asian Develop-ment Bank, etc.). Here, countries have decided that, despite the dilutionof home-country control, evaluation by an international agency is criticalto the agreement’s credibility.

But which international agency or agencies should do the monitoring?I believe the IMF and the World Bank group are the most logical candi-dates. Only they have the universal membership that would include allpotential participants in an IBS. Also, monitoring compliance with an IBSwould require on-site inspections and discussions with local supervisoryauthorities and local banks. The IMF and the World Bank already sendmissions to countries and only they currently have enough personnel tomake on-site visits throughout the developing world. I envision the Bret-ton Woods institutions carrying out at least three functions associatedwith an IBS.

First, the World Bank and regional development banks could incorpo-rate the IBS guidelines into the training, technical assistance, and financialrestructuring advice that they already provide to many countries. In thissense, the IBS would help guide banking system reform in developingcountries and delineate the banking-system preconditions that are neces-sary for developing countries to benefit from greater financial integra-tion.25

Second, the IMF could carry the primary responsibility for determiningwhether countries voluntarily subscribing to the IBS were meeting theirobligations. They would base that determination on off-site analysis andinformation obtained during missions (on-site) to the country. Duringthose missions, they would hold discussions with national bank supervi-sors and a sample of local banks. National banking supervisors wouldcontinue to have the primary oversight responsibility for their banks butthe mission would seek to reach a view, inter alia, as to whether nationalbanking supervision itself was implementing faithfully the IBS guidelines.If a determination was made that a country was not meeting its IBSresponsibilities, it could be given a fixed period of time to remedy the

25. See the recent World Bank report (1997) for an extensive discussion of the preconditionsfor successful financial integration.


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situation. If the country displayed serious and persistent nonobservanceof the IBS guidelines, then the IMF would indicate publicly that thecountry’s subscription to the IBS was suspended. Like the IMF’s SDDS,an electronic bulletin board could be established on the internet listingthose countries that subscribed to the IBS and were in good standing;persistent noncompliance would be signaled by taking a country ‘‘offthe board.’’

This option of taking a noncomplying IBS member off the board isnecessary to give the IBS credibility with private capital markets. If thereare no significant penalties for not behaving as a good club member, thenclub membership will not yield a market return. That said, it would bea mistake for the IMF to create the impression that an IBS member ofgood standing is immune to banking problems. As laid out in chapter 2,banking-sector vulnerability depends on a number of factors in additionto banking supervision, including the state of the macroeconomy and theappropriateness of the country’s exchange rate policy; the IBS does notaddress those sources of vulnerability and implying otherwise wouldonly lead to a downgrading of the monitoring agency’s credibility. Instead,the IMF should make it clear that being an IBS member in good standingcarries a much narrower interpretation—namely, that the country is meet-ing IBS minimum standards of good banking supervision.

Third, the IMF and the World Bank could provide further incentive forsigning on to the IBS and honoring its obligations by factoring compliancewith the IBS guidelines into their policy conditionality decisions and/orby publishing their analysis of banking-sector developments.

By including compliance with IBS guidelines as an element of policyconditionality, the IMF in its stabilization programs and the World Bankin its financial restructuring programs would give those countries seekingfinancial assistance a further incentive to undertake banking reform. Fromthe perspective of the international financial institutions (IFIs), there isgood reason for such conditionality: if nothing is done to overcome bank-ing-sector fragility, other elements of stabilization and financial reformcould be rendered ineffective and the IFIs’ chances of being repaid ontime diminished. Also, at least in crisis situations, some banking systemreforms are presumably already part of Bretton Woods conditionality;the IBS guidelines would just bring a more widely accepted frameworkto that element of conditionality. On the negative side, the more the IBSguidelines become a requirement, the less one captures the aforemen-tioned advantages of a voluntary standard. Also, this additional sourceof leverage would only apply to countries seeking financial assistancefrom the IMF and the World Bank. On top of that, the potential ambiguitiesof judging compliance with an IBS that contains many elements shouldnot be underestimated.

Rather than simply conveying an ‘‘on-off’’ signal to the private capitalmarkets about IBS membership (i.e., country x is or is not a member in


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good standing of the IBS), the IMF could publish a more informativesignal—its analysis of banking-sector developments and the quality ofbanking supervision in individual countries. The IBS guidelines couldthen serve as a useful organizing device for such reports. Presumably,such an analysis would be included with an analysis of monetary, fiscal,and structural policies, in the IMF’s Article IV consultation report for thecountry. Again, such a monitoring role would affect incentives via itseffect on information flows to private capital markets and ultimately onthe country’s cost of borrowing in those markets.

Whether it would be desirable to release to the markets that part ofIMF consultation reports containing the staff’s analysis of economic poli-cies and prospects has been hotly debated for at least a decade, andpublishing an assessment of banking system soundness focusing on IBSbenchmarks raises a similar debate; that is, enhanced market disciplineversus concerns about precipitating crises and reducing the frankness ofIMF consultations. Although the choice is not an easy one, I have con-cluded elsewhere (Goldstein 1995a) that, on balance, there is much moreto be gained than lost from publishing Article IV reports, and I wouldextend that conclusion to analyses of banking systems as well.

At least three criticisms might be leveled against such a monitoringrole for the IFIs.

For one thing, it can be argued that IFIs do not have enough personnelwith the requisite training and experience to make reliable evaluationsof banking systems and banking supervision. This criticism carries somecurrency but should become less relevant over the medium term. Boththe World Bank and the IMF have gained valuable and wide-rangingexperience in assessing and providing technical assistance on developing-country banking systems. Yet, if an IBS were agreed on, their increasedresponsibilities in this area would no doubt require additional staff withbanking supervisory expertise. This will take some time. In the interim,some assistance might come from short-term loans of bank supervisorsfrom G-10 countries and from those emerging-market economies withmore advanced supervisory systems.

A second line of criticism is that the IFIs are too politicized to makethe hard decision of taking a nonperforming IBS member country off theboard. But the IFIs have shown a willingness over several decades tointerrupt their loans to countries under stabilization and restructuringprograms when the latter have failed to meet agreed on performancecriteria (a decision that can also generate significant effects in privatecapital markets). Why should suspension from the IBS be different in kind?

Yet a third objection is that having the IFIs comment—perhaps evenpublicly—on the performance of national bank supervisors would com-promise the latter’s independence and effectiveness. I find this argumentunconvincing. To begin with, there is something to criticize. As detailed


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in chapter 2, there is no precedent for the wave of severe banking crisesthat have enveloped developing countries over the past 15 years; likewise,there have been some serious breakdowns in banking supervision inindustrial countries, including that surrounding the current Japanese bank-ing problem. Moreover, the contention that banking crises had little todo with banking supervision does not seem to be supported by existinganalysis. Caprio and Klingebiel (1996b), for example, studied the factorscontributing to 29 severe developing-country banking crises from 1980to 1996 and concluded that poor supervision and regulation (broadlydefined) were instrumental in more crises than were any other factor(e.g., recessions, declines in the terms of trade, fraud, lending to stateenterprises, political interference, and deficient bank management). Also,one should not confuse independence with immunity from IFI criticism.For example, IMF and OECD publications have long provided an assess-ment of national monetary and fiscal policies (including evaluation of themonetary policies of independent central banks), without any claims thatsuch assessments reduce the effectiveness of national authorities. Whythen should national banking supervision receive a ‘‘special’’ exemptionfrom such international surveillance?26 Indeed, with serious banking prob-lems continuing to surface at disarming frequency (note the recent prob-lems in South Korea and Thailand) and with weak national bankingsupervision identified as an important contributory factor, it seems incum-bent to ask, ‘‘Who’s supervising the supervisors?’’

26. Another possible instrument for international assessment of national supervisory policieswould be ‘‘peer review’’ within the Basle Committee. While this would probably be someimprovement over what we have now, such an exercise could easily succumb to ‘‘nonaggres-sion pacts’’ that essentially eliminate criticism. See Bergsten and Henning (1996) on howsuch nonaggression pacts have reduced the effectiveness of peer pressure within the G-7.


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Documents

Operational Issues Associated with an IBS · OPERATIONAL ISSUES ASSOCIATED WITH AN IBS 35 n If nothing is done to make government policymakers more accountable for granting ‘‘too